Bottoms Up

By

Jacqueline Doherty

Updated Oct. 9, 2000 12:01 a.m. ET

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E ven though the markets have felt painfully volatile, they've actually gone nowhere for the better part of the year. The Dow Jones Industrial Average is right back where it started in May 1999. Indeed, the key average has undergone its longest period of consolidation since the bull market began in 1982, according to the folks at Salomon Smith Barney. The other averages haven't fared much better. The S&P 500 has been stuck in a clearly defined range since January, and Nasdaq has shared the same fate since April. This type of churning often indicates that sellers have become more active and buyers are not willing to enter the fray at current prices. Therefore, the market fails to climb higher.

The Dow's extended consolidation has market technicians -- the folks who look at chart patterns to predict the future-divided. One camp believes the market is in the midst of creating a top; people in this camp expect the averages to either tumble or go nowhere for many years. Those in the other camp believe that the current consolidation period is setting the stage for a rally, perhaps as soon as next year.

The last time the markets went sideways was in 1994, when the Federal Reserve raised interest rates. Once the central bank ended its tightening phase, the markets began to climb again, as became evident in 1995.

But if Alan Shaw, senior technical analyst at Salomon Smith Barney, is correct, we won't see a repeat of 1994's happy ending. This time around, the market is far more extended than it was six years ago, when the Dow traded around 4000, he argues. In '94, the Bull had only 12 years under its belt. Now Wall Street's favorite four-legged creature is celebrating its 18th birthday. In addition, the advances in recent years have been phenomenal. The markets have risen by more than 20% in each of the past five annums. Now it may be time to digest some of those gains.

"It's possibly part of the process of reverting to the mean," Shaw explains. Some analysts believe that after a number of years of excessive gains, the markets will either fall or tread water to revert to the long-term mean return.

There is, of course, always the question of what period to use in calculating the mean. The market has gained an average of 8.44% annually over the past 50 years, ending in 1999. But during the past 20 years, it has posted average annual gains of 13.99%. For the past 103 years, the annual gain was 5.64%.

For argument's sake, we'll use the 50-year period. To return to the 8.44% mean, the Dow would have to suffer a 53.65% one-time drop or it would need to move sideways for the next 15.02 years, the Smith Barney folks calculate. For the S&P 500, the 50-year mean is a 9.33% annualized return. To revert to the mean, the S&P would have to drop by 45.6% in one year or log no gains or losses for 7.83 years.

Eight to 15 years of consolidation may sound extreme until you consider that it has happened before. The market moved sideways for 16 years, from 1966 to 1982.

"This consolidation can't be a bottom. We haven't gone down yet," says Shaw. Important levels to watch for the Dow, he says, are 10,300, a figure that held up a number of times when the market fell in May, and 9800, the low hit of March. The Industrials closed Friday at 10,596.54.

If the Dow is at a top, the other indexes are at risk as well, because investors tend to sell holdings in which they still have profits when the market turns nasty. Such negative momentum, therefore, would also drag down the S&P.

"The best-case scenario is the market stays in a trading range," says Frank Gretz, a market analyst at Shields & Co. He sees signs of weakness in Nasdaq's former powerhouse stocks. Some of the index's most infamous members are no longer pushing it higher.

Gretz points to
Cisco Systems
,
Intel
,
Microsoft
,
WorldCom
,
Dell Computer
,
JDS Uniphase
,
Oracle
,
Yahoo
and
Applied Materials
as examples. Many of these onetime darlings now trade at or near their 52-week lows. Among them were Yahoo, which closed Friday at 81.25, down 68% from its peak of 250.06, and WorldCom, which ended the week at 25.19, off 59% from its peak of 61.33. Intel, meanwhile, wound up at 39.44, down a stunning 47% just since the end of August.

True, there are other areas into which money has flowed, like the business-to-business Internet stocks. But the old leaders that Gretz named represent 32% of the Nasdaq composite. It will be hard for the index to advance if the old leaders don't start showing some signs of life. "The stocks that dominate the averages don't look good," he says.

Another point of concern: The indexes are each hovering around their 200-day moving averages. The trend line created by the 200-day moving average tells technicians whether the indexes are in an up- or down-trend. Recently, the trend lines have flattened out. When the markets were rallying in years past, those lines headed north. So Gretz will closely watch how the Dow moves around its 200-day moving average of 10,800 and the same is true for the S&P 500's 1450 level and Nasdaq at 4050. (For another technician's analysis of the market, turn to page 16.)

Not everyone is quite so dour, however. Richard McCabe, chief market analyst at Merrill Lynch, believes the Dow will continue to consolidate and perhaps retest its recent lows. But then the index should head north to hit a new high within the next year. He doesn't expect a repeat of the benchmark average's extended 1966-82 consolidation, because it has already experienced enough of a correction to move modestly higher over the next two to three years.

That said, the returns of the stocks in the Dow could end up trailing those of small- or mid-cap issues that haven't experienced the Industrials' phenomenal returns over the past 10 years.

So, how will McCabe know when the current churning phase is completed? He's watching investor sentiment. Indicators like the put/call ratio and surveys of market letters should indicate when investors hit the point of maximum pessimism and have likely finished selling shares. For example, Investors' Intelligence reports that only 30.9% of financial advisers' market letters are bearish about prospects for stocks. When that number rises to 45% or 60%, the market is ripe for a rebound, McCabe contends: "When the sentiment figures show some healthy caution, then the consolidation may be over."

Some potential scenarios: The Dow could finish its consolidation phase by November and then advance through 2001; or the market could stage a yearend rally and retest its lows in the spring before moving on to new highs. After hitting another new high, perhaps of 12,000, the Dow could then proceed to fall or post anemic returns to revert to the mean over the next five to 10 years.

McCabe isn't as optimistic about the Nasdaq, however, because it hasn't been consolidating for nearly as long as the Dow. He warns, "It's going to take more time for the Nasdaq to make a new high."

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